Tag Archives: risk of inflation

The Central Banks: Who will Save the Lifeguards?

Modern central banks are the lifeguards of our financial system. When our financial system is drowning and the economy is sinking beneath the waves, it is the central banks that must come to the rescue. But what happens when the people tasked with saving the system are out of effective options? Who will save the lifeguards when they’re drowning?

Only twenty years ago, the notion that the lifeguard of the financial system might run out of options and not be able to rescue the economy was unthinkable. The Federal Reserve, and the other major global central banks, could always cut interest rates. With interest rates in the mid or even high single digits, central banks could “slash” interest rates, thereby providing a massive boost to economic activity.

If this drastic action failed, then the central banks could use the “last resort option”: printing money. Everyone believed that printing money would have an immediate and positive effect on stabilizing financial markets and promoting full employment. In a way, they were right: QE has certainly promoted “stability”, or what others might call “speculation”, in financial markets.

However, the very real question that confronts us now is what happens in the next crisis? What tools do the central banks have left at their disposal to deal with the next crisis? And will these tools be effective at saving the markets and the economy? And if the central banks fail, then who will step up and save the economy?

At this point in time, confidence in the economic future of the United States is high. Very few of the investors that I met with recently in New York believe that any sort of serious economic disruption is coming in the immediate future (next 12-18 months). But what if it does? After all, the current environment of economic optimism is very similar to that which preceded both of the previous recessions.

What if 2015 turns out to be a year of deep recession, or worse, a year in which the global banking crisis returns? What strong, bold actions can the Fed take from here? What can the Bank of Japan do that it has not already done? What aggressive steps can any of the central banks take without risking their credibility, destroying the value of their respective currencies and driving up the price level?

The central banks have a problem. In their rush to be all things to all people, they have forgotten to prepare for their most important role. In order for the central banks to act as the lifeguard of the financial system, they must keep something in reserve. This they haven’t done.

We can think of this by way of simple analogy. When someone is drowning, a lifeguard must race out into the water, swim through the waves, get that person on their board and bring them back ashore. This is the glamorous part of being a lifeguard that we see on television reality shows.

However, the part we don’t see is just as important. The lifeguard must rest and recuperate between rescues. The lifeguard must sit and watch the developing rips and keep an eye out for those that are getting into trouble. Most importantly, the lifeguard must remember that she is a lifeguard. She can’t be down at the beach just “having a good time”.

Moreover, the lifeguard can’t be in the water with all the other swimmers when trouble comes. If the lifeguard is suddenly caught in a rip, then maybe the lifeguard can save herself, but how will she see all the other swimmers that are in trouble and be in a position to rescue them?

The problem for the major central banks is that they have spent too much time in the water (a sea of excess monetary liquidity) and are not ready for the next rescue. Despite the fact that their efforts are well intentioned, the central banks are in a very poor position to react when the next rip develops and starts to drag the weaker swimmers under.

A major part of the problem is the somewhat ridiculous multi-point mandates that the central banks have imposed upon themselves.

Officially, the Fed has three key objectives for monetary policy imposed upon it by Congress: maximum employment, stable prices, and moderate long-term interest rates. From this comes the “dual mandate” of the Fed: maximum employment and price stability.

This dual mandate has already been widely criticized, not just by those on the outside, but by those on the inside. One of the greatest central bankers of the 21st century, Paul Volcker, in his May 2013 speech to The Economic Club of New York titled “Central Banking at a Crossroad”, argued that the dual mandate of the Federal Reserve is “both operationally confusing and ultimately illusory”.

However, the responsibilities of the Federal Reserve extend far beyond this “confusing and illusory” dual mandate. In addition to maximum employment and price stability, the Fed is also tasked with supervising the banks and ensuring the stability of the financial system.

It is this last point that is perhaps the most important role of the Fed. The Fed’s role in ensuring the stability of the financial system is something that is largely taken for granted by the markets. But in its attempts to fulfill its other goals, most notably “maximum employment”, the Fed has embarked on a highly aggressive policy path that will significantly impair its ability to fulfil its most important role just at the time when it is needed most.

If the Fed was not tasked with maintaining “maximum employment”, then the Fed could have unwound QE by now and could have begun the process of normalising interest rates. If a crisis hit today, the Fed could cut rates and re-engage in unconventional policy measures such as quantitative easing. But this is not where we are. Nearly seven years since the last crisis, the Fed has not even begun the process of reducing the monetary base or raising interest rates.

So, what are our options if another crisis hits today?

Frankly, they’re not good.

The major central banks can’t cut interest rates: they’re already at zero. They could print more money. However, it’s far from clear whether the beneficial effects of this action would offset the potentially negative effects of this action. Clearly, it depends somewhat upon the nature of the crisis. If the crisis was related to some part of the private credit markets (student or auto loan defaults), then the Fed might be able to dampen the effects of the crisis by buying up these loans and the impact on inflationary expectations may be small.

However, if the crisis involved a loss of faith in the long-term economic outlook of the United States, then any actions by the central bank may be counterproductive. Ramping up the monetary base from unprecedented levels to even more unprecedented levels may not be the best solution for restoring confidence. Rather, it may be the straw that breaks the camel’s back: an act that triggers a loss of faith in fiat currency, which in turn ignites a wave of global inflation that wreaks further havoc in the global financial markets.

If the central banks can’t solve the next crisis, then who can?

Clearly, fiscal policy makers could always revert to the first (and only) recommendation in the Keynesian playbook: spend more money.

Again, this is a fine idea in the right circumstances. A country with relatively low levels of government debt to GDP can, and should, issue debt to support the economy in a time of crisis. But we don’t live in that world today. Government debt to GDP is now at levels that have only been seen in a time of war.

Once debt levels reach a certain point, taking on further debt to support the economy becomes counterproductive. Maybe we are not at that point yet. Maybe we are. The problem is that we should never be in the position where we are even contemplating crossing that line in the sand.

So the question remains. What happens in the next crisis? Who will save the lifeguard when the lifeguard is about to drown?

A Bubble of Confidence Obscures the Risk of Inflation

A quick scan of recent financial headlines would suggest that the Western World is on the verge of a major contraction in prices. One commentator after another argues that deflation is the great risk to global economies and markets.

Ironically, the current period of relatively low inflation is the flipside of the overvaluation in global bond and equity markets. More specifically, there is a bubble of confidence in all asset classes. This bubble of confidence is supporting not only debt and equity markets, but supporting the value of the major fiat currencies. It is this overconfidence in money that is keeping a lid on the price level in the major Western economies and helping to drive the price of commodities (and gold in particular) to new lows.

The Federal Reserve’s unprecedented actions since the 2008 crisis have led to a surge in confidence regarding the long-term economic prospects of the United States (and thereby the long-term prospects of the world economy). The notion that the United States is steaming ahead and will pull the rest of the world with it is a common theme in current financial market commentary.

This surge in confidence regarding the long-term outlook has permeated global asset markets. Government bond prices have soared (particularly in the European periphery ex-Greece) and this has fed a search for yield in corporate debt. Prospective risk-adjusted, nominal returns on a broad portfolio of global government and corporate debt are close to 0%. (You don’t have to have many positions go wrong in a global fixed income portfolio with an ex-ante 2-2.5% headline yield for the ex-post yield to be 0%).

Furthermore, as prospective fixed interest returns have collapsed, investors have chased global equities higher and higher to the point where prospective ten-year nominal returns on the US equity market are also close to 0%. (See John Hussman’s commentary for an excellent discussion of this issue replete with long-term valuation charts).

More interestingly, this surge in confidence has supported the market value of fiat money, the denominator of every “money price” in the economy and thereby suppressed prices as stated in money terms. Despite the massive increase in the US monetary base, the market value of the US Dollar has been supported by a surge in confidence regarding the long-term prospects of the US economy.

Why has the US Dollar seemingly ignored the massive increase in the monetary base? And why has the market value of the US Dollar been so sensitive to a surge in market confidence regarding the long-term economic future of the United States? The answer to both questions is that money is a long-duration, proportional claim on the output of society.

The theory developed in The Money Enigma, the first paper in The Enigma Series, is that money is a long-duration, proportional claim on the future output of society. In essence, what this means is that the value of money today depends upon expectations of what the ratio of real output to base money will be over the next 20-30 years. The ratio of output/money as it stands today is somewhat irrelevant to the value of money. What matters is the expected path of that ratio over the next 20-30 years.

Let’s break down this concept into its two main components.

  1. Money is a long-duration asset

If an asset is described as being a long-duration asset, then all this means is that a large part of the current value of the asset is tied up in benefits that should be received from that asset in the distant future. For example, a 30-year government bond is a long-duration asset because the principal repayment on that bond is not due for 30 years and the interest payments are spread out over the next three decades.

Money is a long-duration asset because its current market value depends largely upon benefits that will be received from spending that money in the distant future. More specifically, in a state of intertemporal equilibrium, we are indifferent between spending the marginal unit of money demanded now, in 5 years from now or in 20 years from now. (If this were not the case then the economy would not be in a state of intertemporal equilibrium). This somewhat complicated notion is explored at length in The Velocity Enigma, the final paper in The Enigma Series. Fortunately, there is a simpler way to think about this issue. The value of money depends upon a chain of expected future values.

When I buy a product from you and give you money in exchange, you expect that the money I give you should have a similar purchasing power (a similar market value) when you spend it. When you spend the money, the next person accepts it because they believe it will have a similar future purchasing power. This process continues all the way down a chain of thousands of people.

Therefore, if the market suddenly decides that money will have less value in some distant future period, then that will have an immediate impact on the current value of money.

Conversely, if the market is optimistic in regards to the future of money, then that confidence will support the current value of money, even if the monetary authority has recently created a lot more money (does this sound familiar?).

The point is that money is a long-duration asset and its value today depends upon future expectations. But future expectations of what? This brings us to the second part of the earlier statement.

  1. Money is a proportional claim on the output of society

Money is a financial instrument. This means that money derives its value contractually. More specifically, money is a special-form equity instrument issued by society (money is a legal liability of government, but an economic liability of society) and money represents a proportional claim on the future output of society. The view of The Enigma Series is that an implied-in-fact contract exists between the issuer of money (society) and the holders of money (again, society) that recognizes money as a proportional claim on the future output of that society.

Money is much like a share of common stock. One share of common stock is a proportional claim on the future cash flows of a company. If the number of claims rises (the number of shares on issue rises), then all else equal, the value of each claim falls. Similarly, if the expected future cash flows of the company fall, then the value of each proportional claim on those cash flows falls (the current value of each share falls).

Money is a proportional claim on the future output of society. If the number of claims rises (the monetary base increases), then all else equal, the value of each claim will fall. However, if the expected future output of society rises, then this will increase the value of the proportional claim on that future output (the value of money rises).

In summary, money is a claim on the future output of society and the current market value of money depends upon expectations of the long-term path of the “real output/base money ratio”.

So, how does a surge in confidence regarding the future prospects of a country impact the value of the currency issued by that currency? Clearly, such confidence will support the market value of that currency.

The near-term path of the “output/money” ratio is fairly irrelevant to the value of money. If the market expects the monetary base to decline over the next ten years and economic output to continue to grow strongly over that period, then that confidence is enough to support the value of money and, conversely, keep a lid on inflation.

However, there is a risk.

If confidence in the future prospects of the US collapse, then we would naturally expect the bond and equity markets to suffer. However, such a collapse in confidence will also impact the market value of the US Dollar.

As discussed in last week’s post, every price is a relative expression of the market value of two goods. If the market value of money suddenly declines, then, all else remaining equal, the price of all goods, in money terms, will rise sharply.

The markets are not prepared for this eventuality. But the prospect of a sudden and severe increase in the rate of inflation is a far more likely than a return of 1930s-style deflation. All it will take is one pin that pops the bubble of confidence that currently permeates all global asset markets.

Inflation or Deflation: Which is the Greater Risk in 2015?

Could 2015 be the year the markets experience both a “deflation scare” and an “inflation scare”?

The recent collapse of crude oil prices below $60 per barrel, combined with additional signs of global economic weakness, have renewed fears about an outbreak of deflation in the United States. Six years have passed since the US Federal Reserve first embarked on its current path of quantitative easing. The US Federal Reserve’s balance sheet has increased five-fold and other global central banks have followed in their footsteps. Despite this remarkable growth in the global monetary base, inflation has remained subdued.

The view of many in financial markets is that global deflationary forces are just too strong and that global central banks are increasingly impotent in their battle against deflation. This also seems to the view of at least one dissenter at the US Federal Reserve, Fed “dove” and Minneapolis Federal Reserve Bank President, Narayana Kocherlatkota, who argued that the Fed should be willing to further expand the monetary base if inflation continues running below the Fed’s 2% target.

While it may not be explicitly acknowledged by those who hold these deflationary expectations, this represents a quintessentially “Old Keynesian” perspective regarding the way the world operates. In essence, it is the view that if aggregate demand is weak, then prices must fall. Moreover, if global competition is pushing the aggregate supply curve to the right, then this only compounds the deflationary pressures.

The problem with this view is that it represents a very “one-sided” perspective on how “money prices” are determined in our economy. While it is true that well-entrenched deflationary forces (i.e., falling oil prices, global economic stagnation, and increasing global competition) have, and will probably continue to, put downward pressure on the value of global goods and services, there is a key element that is missing from our analysis: the future path of the value of money.

The value of money is the denominator of every “money price” in the economy. Every money-based transaction involves an exchange of two items of value. When you buy your morning cup of coffee, you receive one good of value and, in exchange, offer another good of value in return. This is the simple principle of all economic transactions dating all the way back to the barter economy of our ancestors. In our modern money-based society, the good of value that you offer in exchange for your morning cup of coffee is money.

The price of your morning coffee can rise for one of two basic reasons: the value of a cup of coffee can rise, or the value of money can fall. If the value of money falls, then, all else remaining equal, your local coffee shop will require you to give them more dollars for that morning cup of coffee.

We can extend this simple concept to the price level and changes in the price level (inflation). The value of money is the denominator of every “money price” in the economy and therefore the denominator of the price level. As the value of money falls, the price level rises.

In simple terms, this is the “Ratio Theory of the Price Level”, an economic theory of price level determination developed in The Enigma Series. Ratio Theory suggests that any “inflation versus deflation” debate needs to begin with a simple equation. Mathematically, the price level “p” can be described as a function of the value of goods and services “VG” and the value of money “VM” (see image below).

Ratio Theory of the Price Level

Inflation can be thought of as a game of “tug-of-war” between these two opponents. Currently, the world is experiencing strong deflationary forces that are placing downward pressure on the numerator in our equation, the value of goods and services. The current fall in oil prices should only accentuate these forces.

The bigger question relates to the future path of the value of money? The value of money has been relatively stable over the past few years, despite the massive expansion in the monetary base. However, is it reasonable to expect this stability to continue? And if the value of money does fall, then will it overwhelm the steady decline in the value of goods and services? In other words, will the denominator in our equation fall by more than our numerator?

You may ask why economics doesn’t present the “inflation/deflation” debate in these simple terms. Mainstream economics struggles with the concept outlined above because it does not recognize “the value of money” as a variable in its equations. In technical terms, economists struggle with the notion that price is a relative expression of two market values (the market value of a primary good as expressed in terms of the market value of a measurement good). Moreover, economics has largely failed to recognize that the property of “market value” can be thought of in both “absolute” and “relative” terms.

But before we get carried away with economic theory, let’s return to the topic at hand. What is the inflation outlook for 2015?

It seems reasonable to believe that the current weakness in the oil price, should it be sustained, will have some flow through effects over the course of the first few months of 2015. Energy costs represent a significant input cost for many industries and lower oil prices should contain any inflation over the next few months.

However, it seems unlikely that deflation represents the greatest risk to investors in the second half of 2015. Rather, the greatest risk to long-term investors remains a sudden collapse in the value of money and a significant jump in the rate of inflation. Indeed, 2015 may be remembered as a “flip-flop” year: fears of deflation in the first-half of the year rapidly switch to fears of inflation in the second-half of the year.

So, what is the risk of a sudden collapse in the value of money in 2015?

After six years of experimentation with the monetary base, many investors have been lulled into a false sense of security regarding this issue. The view of some investors is that if QE was going to negatively impact the value of the US Dollar, then it would have already happened by now. However, this is a naïve and simplistic view.

Ultimately, the value of a fiat currency is a function of the confidence that markets have in the long-term economic prospects of the society that issued it. More specifically, the value of money reflects expectations regarding the long-term path of the “output/money” ratio.

Over the past few years, markets have become more optimistic regarding the long-term prospects for the US economy. The view is that the US economy will continue to grow strongly over the next 10-20 years, even as the monetary base is “normalized” from its current extended levels.

However, if confidence in this view is shaken, then the value of the US Dollar will come under pressure. For example, if the Fed does reduce the monetary base, even modestly, and this results in a recession in the US, then investors’ long-term confidence in the path of the “output/money” ratio could be quickly shaken. The question for all investors is whether 2015 is the year that confidence turns.

Clearly, the role of expectations in the determination of the value of money and the price level is a complicated matter and future articles will be dedicated to exploring this issue further.

So, is deflation or inflation a greater risk in 2015? Near term, the risks may be on the side of deflation. But longer term, the risks are squarely in the inflation camp.